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The Boards of Directors of companies have always complicated decision making. However, those decisions become incredibly more complex when the company has entered into an “insolvency zone” and is considering bankruptcy. Generally, the Boards of Directors have a fiduciary duty towards the shareholders of the company. That means they must make decisions for the company based on a careful duty, a duty of loyalty and a duty of good faith towards shareholders. In other words, the board of directors must act as reasonably prudent people do and make decisions based on the best interests of the company.
The fiduciary duty of the Boards of Directors changes when bankruptcy is an imminent possibility. Although the Board of Directors still has a fiduciary obligation with the company, the insolvency area may also require that the Boards of Directors exercise their fiduciary duties with respect to the creditors.
How do the Boards of Directors know that they have penetrated an insolvency zone?
It can be difficult to determine when a company becomes insolvent. It takes time for the financial books to reflect the current condition of the company. Therefore, the courts have created a concept called the insolvency area. The insolvency zone begins when the company is in financial difficulties and, possibly, can become insolvent. In general, the courts apply either a balance sheet test or a cash flow test to determine whether the company should be considered in the insolvency zone. The courts that apply the balance sheet approach will consider whether the company’s assets are greater than its liabilities and the courts will apply the cash flow criterion to determine whether the company has sufficient cash flow to pay its debts and financial obligations.
Duties of the Trusteeship Councils towards the creditors
Once a company has entered the insolvency space, the Board of Directors still has a fiduciary duty towards the shareholders of the company, but, now, it also has a fiduciary obligation with its creditors. Sometimes this can create a conflict of interest for the Board of Directors since a decision may be in the best interest of the creditors, but not of the shareholders. In some states, the main fiduciary duties of the Boards of Directors go towards the creditors, once a company is in the insolvency zone. In other states, the fiduciary obligation is not shifted to the creditors until a company is officially bankrupt.
In the rest of the States, the Boards of Directors are not obliged to have as a priority the interests of the creditors over the interests of the shareholders, but which are necessary to protect the rights of the creditors. In these complicated situations it is important that the Board of Directors seek legal advice to avoid future legal problems.
A company is not required to seek advice from creditors, nor will it inform them of the company’s financial problems, even if the Board of Directors has a fiduciary duty towards creditors. Likewise, it is important for the Board of Directors to focus on its fiduciary duties towards all shareholders and towards all creditors when answering individual questions about the financial health of the company.
Companies that are within the insolvency zone are often faced with difficult options. It is prudent for the Board of Directors to take each decision with a focus on its obligations of diligence, loyalty and good faith towards shareholders and creditors to avoid future litigation.
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